If the government decides to abolish or alter alternatively secured pensions in the pre-Budget Report, pensioners will be left with no choice but annuities past the age of 75, but are these still a viable proposition?
Decumulation options for pensions are slim with a straight choice between drawdown and annuities, but over the last few years annuity prices have steadily increased as the demand for gilts - the long-term government bonds which back annuities - has started to outstrip supply.
This means pensioners are paying more today for the same amount of income pensioners were receiving just two years ago, with figures from the Association of British Insurers (ABI) showing the average price of an annuity today is £38,879, while in 2005 it was £27,027 and just £21,479 in 2004.
But in addition some parts of the industry believe annuities are particularly poor value before the age of 75 because of the decline of mortality cross subsidy, where an annuity holder dies and the remainder of the fund is distributed among other annuity holders.
John Lawson, head of pensions policy at Standard Life, says based on current mortality rates for 60-year-old males and females, a joint life annuity with two-thirds spouse’s pension and long term interest rates of 4% would produce an annuity income for a 60-year-old man of £5,618.
But he says if you add a 15-year guarantee to this product, which effectively takes out the effect of mortality cross subsidy before the age of 75, the annuity drops to £5,464 a fall of just 3% compared to 10 years ago where the lower mortality rates meant there was a drop of 12% between the two annuities, meaning the benefit of mortality cross subsidy has declined by 9% in the last decade.
In addition, Lawson suggests the A-Day changes which allow trivial commutation of pension funds up to £15,000 could also weaken the mortality cross subsidy, as in general those with smaller funds are likely to less well off, and those from poorer backgrounds tend to have a shorter life expectancy.
He says: “By removing smaller funds from the annuity pool, the shorter lives of those people are no longer subsidising the longer lives of those with larger funds who are likely to live longer, the healthy wealthy.”
As a result, he claims as annuities are simply a package of mortality cross subsidy and fixed-interest investments, such as gilts and corporate bonds, if mortality cross-subsidy disappears, then all the annuitant is buying up until the age of 75 is a package of fixed interest investments.
And he adds: “This package is only likely to suit the risk averse or those who need a certain guaranteed level of income. The remainder of the population, and their advisers, ought to be asking themselves if they could obtain a better return by opting for income drawdown and investing in other asset classes.”
But Kevin Pacey, head of Bank of Scotland Annuity Service, says although this is an interesting train of thought overall there doesn’t seem to have been a reduction in the number of people buying an annuity, while he points out changes to the nature of the annuity pool have been occurring over the past decade, not just since A-Day.
In addition, Pacey says commutation of trivial pensions was allowed pre-A-Day, although on slightly smaller pension sizes, so this has been happening for many years, but he admits there is a lot of anecdotal evidence to suggest people do not understand the implications of A-Day on their retirement options and therefore may not be fully aware of their right to cash in a pension of up to £15,000.
He adds: “Lack of awareness may be part of the reason we aren't seeing a lot more people commute trivial pensions, and this is supported by the fact two in three people are opting to take an annuity with their pension fund provider rather than seek advice about their options and shop around for the best rate in the market.”
Pacey says the annuity pool has been changing for 10-12 years with the introduction of income drawdown and since impaired life annuities became popular, and argues this along with longevity, interest rates and investment returns, has put downward pressure on annuity rates.
However, he believes trivial commutation is not going to have a significant effect on either the popularity of annuities or on their rates, as he points out the number of people with pensions of less than £15,000 is small relative to the size of most annuity providers' books and so is unlikely to impact their business or the rates.
He adds: “The experience of BOSAS is that we are still seeing a similar proportion of pensions below £20,000 as we did prior to A Day. Although drawdown might be a good option for some it is not for those who are risk averse or have lower pension wealth. Similarly it is not suitable for some with higher pension wealth. This all points to the fact that retirement decisions are individual.”
Rachel Vahey, head of pensions development at Aegon Scottish Equitable, agrees there are other factors which can affect the annuity rates and the mortality cross subsidy, with trivial commutation unlikely to play a very big role.
As she points out annuity rates work on the basis of reacting to market changes and although people taking money out of the pool may have some bearing, she says it will not necessarily have a significant effect.
And she agrees with Pacey a lack of advice at the point of decumulation means people may not be aware of the option to commute their pension or to shop around for the best annuity using the open market option (OMO).
She says: “Annuities depend on who you are, and for some they are absolutely fantastic as they provide a guaranteed income for life, and they are the last real guarantee left in pensions, but in passing over all the mortality and investment risk, you also lose all control and can’t react to events, which is what some people dislike about annuities.”
As a result Vahey says there needs to be more development in this area of the pensions market to come up with some middle ground alternative between full drawdown and what some people are calling forced “annuiticide”.
She says: “At the moment I fully expect to live to at least 90, which if you retire at 65 is almost 30 years in retirement, which is an awfully long time to sign yourself up to one product. We need to look at other ways of developing this market so people have more choice. Hopefully the Treasury consultation on decumulation will provoke debate in this area and result in some new ideas.”If you have any comments you would like to add to this story or would like to speak to its author about a similar subject, telephone Nyree Stewart on 020 7968 4558 or email [email protected]IFAonline
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